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with his vendors so they never bothered to check the going market price.
Day one of owning the property, you were able to negotiate the following monthly expenses down:
~Monthly dumpster fee from $110 to $95 — an annual savings of $180
~Per cut grass cut expense from $150 to $100 — an annual savings of $1000
~Property management fee of 8% down to 7% — an annual savings of $1,600
This all doesn’t seem like much, and was really simple to do. Let’s see how it effects the returns in our example.
After increasing income $5,700 a year and simultaneously decreasing expenses $2,780 you were able to increase the money you put in your pocket $8,480. The extra cash is nice, but the real power behind this is the fact that commercial real estate is valued based off the income it produces. Since you increased the income the properties produces, you also increased its value.
Let’s look at how this affected our example. Your property still is in the same market and asset class that awards it with the same capitalization rate of 8% that you bought it for. Now that you have found ways to add $8,480 to the net operating income, this gives you a total net operating income of $88,480. By dividing the net operating income by the cap rate, we can find the new value of the property.
$88,480/.08 = $1,106,000.
That’s right! Making those minor changes increased the value of your property $106k.
Your mortgage didn’t change, so you still owe the same — you simply raised the equity you have in the building $106k without putting a single dollar more into the investment.
New & Improved Totals
To find what the all inclusive return is now that you have added value, add $8,480 you your taxable income, which will result in an additional $2,968 due to the tax man. This takes your new and improved total after tax cash flow to $36,472 — or an after tax cash on cash return of 18.2% Add in your total $120k equity accrued in year one ($14k from amortization and $106k from forced appreciation), and you have an all inclusive return of 78% (($36,472 + $120K)/$200k).
Now that you found a way to make all this money, you may be thinking the taxes will hit hard once you sell the property. My first response is, “Why sell it?” This is a fantastic property. Hold on to this cash cow, milk it, pull all the equity out in a cash out refinance, which is not a taxable event, put it in a trust, and hand it off to your heirs.
Or if you love the velocity of money and are looking for the biggest bang for your buck, sell it. But do so in a 1031 exchange, which defers all tax into the next property purchase. Do this until you die, and the taxes die along with you.
And that is how the wealth is built in real estate.
By Jered Sturm | August 12, 2016
posted on biggerpockets.com